A solid strategy can turnaround a company in a matter of months - we can see how it has changed for Chesapeake (CHK), and how the stock has reached the heights not seen in the past two years. Under the previous leadership, the company focused on accumulating assets and in the end suffered due to the decline in natural gas prices. The current leadership has taken a completely opposite approach and it is currently focused on shedding excess assets and bringing a balance between natural gas and oil production. As a result, the stock has received positive reaction from investors and currently trades at the highest price in the past two years.
What has Changed for the Company?
The shale boom caused the problem of oversupply in the U.S., which resulted in natural gas prices falling down to the record lows. It was natural for the second largest natural gas producer to suffer due to the fall in natural gas prices. The situation needed a quick change in strategy as the company was losing money, and most of the assets acquired during the shale boom were becoming economically unviable due to the falling prices. As a result, profitability and balance sheet both came under severe pressure.
However, the change in strategy has worked well for the company. There were two main parts of the new strategy: A profitable balance between oil and natural gas production, and decrease in future capital investments (also the company decided to shed a big chunk of underperforming or weak assets). Oil production in the third quarter went up by 23%, which resulted in the company reporting better than expected results.
At the moment, Chesapeake, ConocoPhillips (COP) and other American companies are focusing on the high-priced crude oil (Eagle Ford Shale) in order to achieve higher margins. Chesapeake announced that weather disruptions and asset sales will cause a decline of 9,000 barrels per day in the oil production, which caused the stock to fall slightly. However, we are more concerned with the long-term direction of the company. The question here is that for how long Eagle Ford Shale can accommodate these players? It will difficult to sustain the increase in the production in the long-run as the companies are extracting at an extremely rapid pace. ConocoPhillips increased its production from the region by 66%, and now it equates to about a quarter of its total production. Nonetheless, these firms should be able to sustain the production growth rates in the short to medium-term.
Can the Strategy Backfire?
In the energy sector, it is extremely important to spend on future asset accumulation. At the moment, Chesapeake is focusing on streamlining the assets, which has raised concerns whether the company will be able to maintain growth in production in the long-run. As a cost cutting measure, the company will be operating 59 rigs in the fourth quarter of the year, compared to 73 in the last quarter. Furthermore, the CEO has announced that capital expenditures will be further reduced in the next year.
Chesapeake and ConocoPhillips both spent over $14 billion in capital expenditures last year. And if we take into account the capital expenditures of Chevron (CVX), Exxon Mobil (XOM) and Royal Dutch Shell (RDS.A) (RDS.B); the company is already behind these giants as all of these companies spend over $30 billion on capital expenditures every year. However, an important factor to consider here is the cash position of these companies. All of the above mentioned companies have massive free cash flows (excluding ConocoPhillips), compared to negative free cash flows of over $13 billion for Chesapeake. So, it is necessary for the company to continue asset sale and decrease capital expenditure in order to generate cash. I do not believe the company plans to carry on with the strategy for too long - however, it is a necessity in the short-term. The production for Chesapeake will continue to increase over the next year, and I believe the profitability will also improve. In the medium to long-term, we will see another change in strategy as the company will again start to build its asset base.
Chesapeake is trading at a discount to its peers at the moment based on price multiples - the stock has P/E ratio of 12.8, compared to the industry average of over 32. Moreover, Price-to-book ratio and price-to-sales ratio for Chesapeake stand at 1.3 and 1.0, compared to the industry averages of 1.9 and 2.7, respectively. I believe the asset sales and cost cutting measures will continue to enhance the performance and the balance sheet of the company in the short-term. However, in the long-run, the Chesapeake will need to make a slight change in its strategy.